Where next for UK commercial property?

Commercial property forecasts have suffered downward revisions for this year and through to 2020, Andy Brunner, investment strategist at Morningstar, examines the outlook…

The outlook for UK commercial property is no longer what it was. Investors are now faced with the prospect of lower returns from the main vehicles, directly invested property funds.

While likely to exceed cash, given the strong sustainable yield, performance may not compensate for the illiquidity of the asset class.

UK commercial property capital value growth (CVG) peaked in June 2014 at a monthly annualised rate of 19.1% and from a quarterly perspective in Q2 2014 at 13.3%.

Thereafter the Investment Property Databank (IPD) index has gradually slowed to the extent that CVG in Q4 2015 was roughly half the peak level. The slowdown has continued into the early part of 2016 and forecasts for the full year have suffered downward revisions.

2016 total return forecasts are now down to 7.9% from 9.3%, one of the more sizeable reductions reported in just three months. Minimum and maximum forecasts have declined significantly, the former to just 2.6% from 6.7%, and the latter to 10.1% from 13.0%. Returns for the 2017-20 periods are forecast at broadly 5.0% p.a.

Over this cycle, the IPD index has outperformed all the UK Direct property funds quite considerably, albeit not surprisingly given the cash levels held in the funds. With little reason to expect this to change it seems quite possible that if IPF forecasts are correct, funds may return 4-5% in 2016 with even lower returns over the 2017-20 period.

With growing risks to the UK economy from slowing global growth and Brexit, it is not inconceivable that hot money which moved into the sector chasing prior double-digit returns could exit again. The possibility of more managers moving the pricing basis downwards to deter investors from exiting funds is an added and unpalatable risk.

In addition, it is worth noting that UK property shares have declined substantially over the past five months with the two sector majors, Land Securities and British Land, underperforming the FTSE All Share index by nearly 20%.